No. of Recommendations: 64
There is an asset class rarely discussed on METAR, but is the most important class for most Americans IMO. This is NOT an important asset class for a low percentage of investors. I will spell out the case for why this in an important class, who it is important to and some actionable plans to implement. At this point you are probably wondering what asset class I am referring to: stocks, bonds, REITs, gold, currencies, farm land or tickets to the latest Lady Gaga concert. The answer would be E, none of the above. The asset class I am referring to is “human capital.” In this context, human capital is the productive earning capacity of an individual or family. Normally human capital is NOT referred to as an asset class, but hopefully I will make the case of why it should be. Several points:

1) We can lobby, cajole and chastise as much as we want, but the bottom line is that American’s are horrible savers. We will stipulate that most METARites do not fit this characterization. As you read this post, you will have to decide where you fit along the spectrum of savers. The Employee Benefit Research Institute (EBRI) tracks all manner of retirement finance issues for Americans. In 2009, they published: “Individual Account Retirement Plans: An Analysis of the 2007 Survey of Consumer Finances, With Market Adjustments to June 2009”

Here is the median defined contribution plan account balance shown by age of the person.

Age Retirement Plan Balance

< 35 $6,306
35 – 44 $22,460
45 – 54 $43,797
55 – 64 $69,127
65 – 75 $56,212

(Figure 7 on page 13 for those interested)
Link to full paper:

2) We do not know exactly how the savers built up these retirement plans. Presumably it was some combination of personal savings and investment returns. There are a countably infinite number of ways to arrive at each of these dollar figures by varying the amount of savings and investment returns. So to have a starting point, I made the following assumptions:

a) Family had the 2008 median family income of $50,303
b) Income perfectly tracked inflation, so that the real income was the same throughout
c) Family started saving at age 25 and continued through age 65
d) Saved 1% of salary each and every year
e) 4.46% real return each and every year

This yields an account balance of $56,212 which perfectly matches the median value of the 65 to 75 year old group by design.

(Yes, I know I am lumping together individual savers and family income which is somewhat inconsistent.)

3) This account balance of $56,212 with a median family income of $50,303 represents about 13 months of salary.

4) If we think our investment crystal ball can outperform over a 40 year period, the question is how much alpha can we add? Can we get an additional 2% real return per year? We will use that without going into detail of how likely it is. This raises the real investment return from 4.46% to 6.46%. The portfolio value is now $93,615 or 22 months of salary. So compounding does work and we are able to almost double the account balance.

5) A common way to look at retirement savings is “What is a safe withdrawal rate such that I do NOT run out of money?” Most people have settled on 4% to 5%. If we assume 5% and current actual account balance of $56,212 we are able to payout $2,810 per year. Note that this is NOT a significant amount compared to the annual salary.

6) You might say “But Yoda, you are not considering after tax savings” which would be correct. My reply is what after tax savings? I am confident that many of you saw the recent survey that showed 64% of families could NOT come up with an extra $1,000 for an emergency. For purposes of this analysis, I am going to use a broad brush and assume the family has zero after tax savings. If you want, you could raise it to $1,000 or $2,000 or $5,000 and it will not make a significant difference.

7) Human capital can be modeled as an inflation adjusted immediate annuity that stops paying when you leave the job. You could also model it as an inflation adjusted bond that has zero principal payout on maturity. The implication once again is that income perfectly tracks inflation.

8) BOTTOM LINE 1 is that for a high percentage of Americans, they should be much more concerned about their human capital than their investment capital. Instead of worrying about bonds, stocks, gold, currencies, they should primarily be concerned about a job.

9) BOTTOM LINE 2 is that that you should do everything possible to stabilize, preserve, protect and maximize your return on human capital if you are in this class of low savers. There are several sub points to this:

a) Do whatever you can to always have a job. In some cases, there is a tradeoff between a “better” job and a more “secure, stable” job. In today’s job market, stable jobs should command a premium even if you have to accept lower income.

b) Job training is important. You are probably thinking about college or more college as the best odds to increase the value of your human capital. That is reasonable advice, but is NOT the only path. Recently Boston University economist Laurence Kotklkoff went through an example comparing lifetime earnings of a skilled tradesman to a medical doctor. His analysis showed that lifetime earnings were surprisingly close. The main reason was that the tradesmen started earning income at age 18. The medical doctor started at 30 plus had significant debt to pay off. The medical doctor made more after they started working, but it took a long time to catch up to the tradesman that had a 12 year head start. The moral of the story was that some folks would be well advised to go into a skilled trade position instead of a college path.

c) I have not included it is this analysis, but the elephant in the room is medical/dental costs including insurance. The assumption is that your employer will provide most of the insurance costs. If you find yourself unemployed before Medicare kicks in, it can be insanely expensive. I know “healthy” families that pay $25k to $50k per year for medical/dental insurance. Healthy in this regard means no heart disease, cancer, leukemia, obesity and have had continuous medical coverage for many years. An employer can purchase this insurance at say $15k per year group rates. If you are on your own, you will NOT have access to group rates and MIGHT have to pay considerably more. This is a huge financial consideration and almost mandates having a job with benefits for most pre-65 Americans.

10) BOTTOM LINE 3 is that you should strongly consider working additional years instead of retiring, particularly retiring early. Recall that the median worker at 65 years old has a retirement fund equal to 13 months of income. So working an additional 13 months effectively doubles this retirement fund. There is no rational basis to expect any financial portfolio allocation that will consistently have this strong an effect on retirement savings, particularly if risk is included. Stated differently, you could take your entire savings to a Las Vegas roulette wheel and place it on RED. If you win you double your money, if you lose you go to zero which is not exactly a rational way to invest.

11) BOTTOM LINE 4 is that having a job is likely to be the best hedge you can have against extreme inflation or deflation. Broadly speaking, salaries track inflation. If inflation does increase dramatically, you are somewhat protected by having a job, even if there is a lag in your income catching up to prices. In general you are much better protected than nearly all stock and bond asset classes. Yes, TIPS “protect” you from inflation, but nobody would recommend you have 100% of your financial assets allocated to them. Plus TIPS currently have real returns in the range of ~ 0% to 2%. In deflation, IF and it is a big IF, you still have a job, it will be a better hedge for income that the dramatically increased default risk on bonds, and/or bankruptcy risk on equities.

12) BOTTOM LINE 5 is the first actionable item for METARites that have a larger pool of investable assets, regardless of age. People in this category do NOT have enough to ignore financial asset returns. For example, if you have $100 million of investable assets today, most people would say you will NOT run out of money, regardless of your age. But what if you have $250k or $1 million or $3 million? There is a range of assets that you should take time to properly manage and might be equal to or greater in significance than your human capital. In this range, gaining 2% alpha per year MIGHT be significant.

The main consideration is how stable the return on your human capital is. For example if you have a career with zero job security going forward and unknown future job prospects, you should NOT heavily count on the human capital income stream in the future. You would want to have a more conservative, risk averse portfolio since you can not count on your human capital income.

On the other hand if you have a job that you think is highly stable and are comfortable extrapolating the income stream out ad infinitem, you can up your portfolio risk. Once again, think of this income stream as an inflation indexed annuity payment. It lets you swing more for the fences in the rest of your portfolio. Maybe you do not even have a bond allocation in this case. You consider you job income as bond income.

13) BOTTOM LINE 6 is definitely pertinent for METARites. If you are asked by a non-METARite for financial advice, stock tips, asset allocation etc, your default reply should be “The most important thing you can do for your financial future is to have a secure job and NOT plan on retiring early.” Do NOT bother talking about how you recommend they allocate X percent to this, Y percent to that etc. I understand that this is a broad brush and it certainly will NOT apply to everyone that asks you for advice. However, statistically it will be the correct answer for a large majority of Americans.

Congratulations if you made it this far. It is an important topic IMO and one that is rarely discussed and poorly understood. We all intuitively understand it, but rarely talk about it in these terms. With the stipulation that American’s are going to continue to be poor savers, frankly they would all be better off NOT spending any time worrying about getting extra alpha. Just invest your funds into one of the passive portfolios like Couch Potato, Margaritaville or the Bernstein Eight.


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